The money management industry is undergoing what may be its most fundamental change since I’ve been in the business. Nowhere is this more apparent than with the enormous outflows from actively managed mutual funds. While there are surely several reasons for this mass migration, there is no doubt that one big impetus is dissatisfaction with the poor value proposition that many mutual funds offer. Costs to manage funds have come down substantially, but management fees have remained stubbornly high. And this doesn’t even begin to address performance and service issues. A good deal of money is flowing into passive equity funds because they are cheaper. Money is also flowing into bond funds because they are perceived to be safer. These are certainly reasonable responses, but I also strongly suspect that these actions more accurately represent the beginning of a fruitful journey rather than a destination. The recent activity especially highlights the debate between active and passive management. While I very much believe in the value of passive investing in providing cheap and easy access to market exposures, index funds and ETFs are not perfect and will not solve all investment challenges. Further, as an ever-higher proportion of equities are held by passive funds, the tradeoffs between active and passive management will become increasingly important.

One of the most intuitive and effective ways to appreciate the value of active management is simply by observing the universe of 1500 mid cap stocks. These stocks vary in market cap from $1 billion to $20 billion, span all economic sectors, range from young companies to those over a hundred years old, and have growth rates and returns on capital that span the spectrum. It defies all reason and experience to expect all of these extremely diverse stocks would be anything but substantially differentiated in attractiveness as investments. Given the countless ways in which differentiated performance permeates our lives (the Olympics is a great example!), it never ceases to amaze me how strongly some people feel that it can’t happen with investing. I founded Arete partly because I believe it makes sense to profit from these disparities and partly because I see active management as one of the best ways to invest my own money. In contrasting active and passive management, it is also useful to look closely at the way index funds work. An important and often overlooked aspect of most indexes is that they are weighted by market caps. This has the deleterious effect of overweighting overvalued stocks on one hand and underweighting undervalued stocks on the other. As such, most market indexes represent a systematic implementation of valuation errors. When market participants buy certain stocks simply because they are going up (momentum investing), it compounds the valuation errors inherent to market cap weighted indexes. This is an important risk with index funds. Another important difference between active and passive investing regards corporate governance. Some activist investors use the combined levers of stock ownership (or sales of stock) and corporate governance to agitate for change at poorly performing companies. While passive fund managers can send a message to management teams through the proxy process, they are completely powerless to reinforce the message with action. I am quite sure that corporate boards and managers are well aware of how much pushback they may or may not get from investors when formulating executive compensation and other policies. Active investing is necessary to hold managers to task for upholding their responsibilities to shareholders. Finally, for the sake of argument, let’s imagine a world in which everyone owns index funds. No-one owns stocks directly or through active funds. When a company launches a new product, or makes an important discovery, or adds a huge new client, who would be there to adjust the price to reflect the change in underlying value? If all investors were passive index investors, these fundamental changes would never get reflected in the stock price. Now let’s assume a less extreme situation. Let’s assume there are just a handful of active investors and everyone else is passive. This would produce enormous profit opportunities for a small number of investors at the expense of everyone else. The lesson is that active investors are essential to doing the bidding in order to keep markets reasonably efficient. Too many of them and there will be too few opportunities to support them. Too few, and prices will become wildly inefficient. At the end of the day, just like in any other system, there needs to be a balance. Philosophically, I see important benefits to both active and passive methods. I don’t at all dispute that many active funds provide poor value and that many index funds provide useful and cheap access to market exposures. I think it is extremely important though, for investors to be aware that there are tradeoffs and therefore no easy rules-of-thumb. It will be important for investors to appreciate that simply having exposure to markets may not provide enough return for them to meet their financial goals. It is also important to understand that in an environment of low expected returns and significant risks, it will be ever-more important to seek out the opportunities that do emerge. If you or someone you know is interested in learning more about the opportunities for active management, I’d be happy to discuss how Arete might be able to help out. Best regards, David Robertson, CFACEO, Portfolio Manager

Insights

The value investment philosophy has proven to be extremely successful over long periods of time and across many different markets. While there are many strategies that can work at various times, valuation has proven to be an extremely robust way of making money. As happens periodically, however, the excellent historic record of valuation-based strategies has been noticeably challenged recently. For the two years since July 2010, the Russell Midcap Growth index has outperformed its value counterpart by over 2% per year. While such periods of performance differentials are not uncommon, this particular one foots suspiciously well to the initiation of quantitative easing by the Federal Reserve beginning in the latter half of 2010. It is clear that the Fed has engaged in such actions with the intent of keeping the economy humming along by staving off deflationary forces. Despite these extraordinary efforts, however, the US has experienced one of the weakest economic recoveries in its history, unemployment remains extremely high, and recent data points to further slowing from already anemic levels. We believe the continued economic limbo, and underperformance of valuation strategies, can be at least partly explained by a behavioral response to changes in the business landscape. Specifically, Gillian Tett discussed the role of investors’ assumptions about risk in a recent Financial Times article. Citing the research of anthropologist Michael Thompson, Tett describes two important dimensions of assumptions about risk. For one, power can be concentrated vertically in an organization or government at one extreme, or broadly distributed across a crowd horizontally at the other extreme. High levels of government intervention in the market since 2007 have “trumped the power of the crowd in ways that feel alien to investors.” A second important assumption about risk regards the way in which power is exercised. Societies can operate anywhere on a spectrum between a benign, accountable manner and a capricious and harmful one. As power gets exercised in more capricious ways, people become more fatalistic, and adapt their risk management strategies accordingly. The two assumptions are captured by the questions, “Do we assume anybody is in charge, and is the power structure benign?” We believe an unintended consequence of “extraordinary” action (as relates to the Fed and other government policies) is the perception of ever-greater capriciousness. This is particularly harmful to the economy and markets in a couple of ways. First, an important part of the valuation-based investor’s credo is to include a margin of safety in one’s assessment of value. In a world of capriciousness and whimsy, this is excessively difficult to do. The downside is almost always in the ballpark of zero if you just don’t know what law might be created to render your business uneconomic or which policy might unfairly advantage your fiercest competitor. Investors and entrepreneurs don’t avoid risk, they avoid bad risks. Second, value investors are the “sheriffs” of the market in an important sense. In a chaotic and desolate landscape (picture the Wild West, for example), there is virtually no limit to human behavior. In the market, the floor to valuations is normally provided by value investors who, in their own self-interest, see significant opportunities for profit. In doing so, they act out of principle rather than following the herd and these actions establish downside limits to valuation. In the absence of such investors, however, there are virtually no downside limits. This is often intuitive for entrepreneurs, business managers, and anyone tasked with allocating scarce resources to risky projects. When the rules are clear, the referees are fair, and the goalposts can’t be moved, the game is known and dynamic competition can ensue. When these conditions do not apply, however, it makes little sense to accept unknown risk for unknown reward. The consequence is that many participants withdraw. This behavioral dynamic is useful in more than just explaining our economic limbo. This understanding also informs us as to how the situation can improve. In the context of too much debt and weak economic growth, and assumptions of increased capriciousness in policy-making, it will be incredibly beneficial to have a clear and credible roadmap for reducing the debt and deficit. An environment of more benign and accountable exercise of power would facilitate much more normal levels of business activity and investment. Further, despite rich valuations for the market as a whole, there are several cheap stocks and many of the fundamental strengths of the US economy remain in place. Once the reins of capriciousness are released, we expect the drivers of healthy economic growth to return. When that happens, a much more fertile landscape will also be available to valuation-based investment strategies.

Lessons from the Trenches One of our goals with the Arete Insights newsletter is to share our insights into how the investment management business really works. “Lessons from the Trenches” highlights our approach to stock research. Our intent is to share with you some of the tips, tricks, and other tools we have incorporated into our work that may provide you some insights into how we engage in our craft.

In a landscape of uncertainty, it helps to have as many landmarks and signposts as possible in order to navigate successfully. In efficient markets, prices generally serve as good landmarks because they generally represent underlying value fairly accurately. When prices do not serve as very good landmarks for value, however, it is easy to get lost or to head in the wrong direction. As a result, it is extremely useful to be able to judge the quality of available landmarks. Most of the time, most prices in US markets fairly accurately represent underlying values. This happens because there is a large and diverse group of active participants, each with the intent of making money. The lively interaction that ensues among participants ensures that information gets discounted in market prices very quickly and efficiently. Under these conditions, prices can deviate from fair value, but tend to do so only sporadically, over relatively short periods of time and on an idiosyncratic basis. In other words, most landmarks are useful most of the time. As long as you can take an occasional false signal in stride, you should be able to find your way fairly comfortably. There are times, however, when the market does a poor job of establishing useful landmarks in the form of accurate prices. It is extremely important for investors to recognize when this happens so they can switch to other navigational methods and stay on track. The conditions which reduce the quality of landmarks are exactly the opposite of those that provide for accurate prices. For example, when money flows out of a market, it tends to reduce activity (lower volume). Also, when certain types of investors opt out of market activity, the market becomes more homogeneous. The situation that arises out of these conditions is like a boat full of people. A market with a lot of volume is more stable, like a large boat. A market with a broad mix of people is also more stable, like a boat with people distributed fairly evenly across it. When people on a small boat all tend to rush to one side at the same time, however, it creates a dangerous imbalance that can cause the boat to tip over. It’s important to beware that when a small boat like a canoe tips over, it often says more about the clumsiness of the paddler than it does about the turbulence of the water. In the context of the market, this means that under certain conditions, prices and price moves often say more about the market and its participants than it does about underlying value. This provides a useful background for better understanding some recent market activity. Market volumes have been coming down for some time and are even lower now amid the late summer slowdown (picture the small, unstable canoe). We also know there are market participants that can act in a uniform fashion. One example of potential homogeneity is algorithmic trading. These are software programs designed to implement trades. Index funds, for example, use algorithms to manage positions when investors buy or sell shares. At the end of July, Knight Capital Group (a market maker comprising about 10% of market volume) implemented new software. When it did, the program automatically, and inadvertently, started transacting swaths of stocks that were much larger than intended (picture a paddler shifting all of his weight to one side of the canoe). The result was a big imbalance that caused a “splash” in the form of several stock prices being significantly affected. Notably, the mechanisms involved were similar to those in the “flash” crash of May 2010. When situations like this occur, it is easy to see how prices can be significantly affected by factors wholly unrelated to underlying value. As such, they can produce periods of wild and seemingly capricious stock moves that can be confusing and disheartening for many investors. Fortunately, one need not wander aimlessly when markets prices do not provide useful landmarks. If you know a market has low volume and is vulnerable to herding, the first order of business is to be extremely skeptical of prices as accurate landmarks. The next order of business is to find a way to validate existing signals and/or find a better set of landmarks. This is exactly what makes a valuation-based investment strategy so useful. Valuation provides an analytical basis for determining what things are worth. As such, it is insulated from the market conditions that can periodically distort price signals. Since most of us have not arrived at our retirement destination, we will be continuing a journey to reach our investment goals. When it’s hard to navigate by traditional landmarks, inaction is not a useful option; it will only guarantee you won’t reach your destination. Arete’s valuation process can help show the way.